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A Comparative Analysis of Ratios What We Teach and What They Do: A Comparative Analysis of Ratios Dr Jennifer L. Harrison Southern Cross University, Tweed Heads, Australia Email: [email protected] Dr Anja Morton Southern Cross University, Lismore, Australia Email: [email protected] Preferred Stream: Stream 7 (Management Education and Development ) i What We Teach and What They Do: A Comparative Analysis of Ratios ABSTRACT Financial statement analysis is a skill most business/commerce bachelors’ and masters’ degree graduates will need in their workplace, irrespective of their specialisation. For this reason, most related degrees are structured so that financial statement analysis is covered in one of the compulsory first year or core subjects. As educators of future managers we have an obligation to provide our students, at this introductory level, with the opportunity to learn the latest, simple, financial statement analysis ratios. To achieve some measure of the degree to which we fulfil this obligation, a survey was carried out of the financial statement analysis chapters of Australian introductory accounting textbooks to determine the extent to which: 1. the ratios recommended in them are consistent; 2. they include the ratios recommended by Carslaw and Mills (1992) (the only other related prior research known to the authors); and 3. they include ratios used in practice. All of the textbooks surveyed recommended traditional ratios such as the current ratio, return on equity, debtors and inventory turnovers, earnings per share and debt ratio. However, cash flow ratios were found to be covered inconsistently with very limited coverage in most books surveyed. Other ratios, such as the net debt to equity ratio and net tangible asset backing, were also found to be missing, but were found to be commonly disclosed in company annual reports and were covered in other reflections of practice. Keywords: management education, organisational performance, ratio analysis Interpreting an entity’s financial performance and position is an integral part of much economic decision-making and ratio analysis, which is an important financial statement analysis tool (Gallizo, Jiménez & Salvador 2003), is used in all aspects of business – finance, management, marketing and accounting. Financial statement analysis is a skill taught in universities to first year business students and although textbook authors in this area, as in others, have an obligation to keep all aspects of their content up-to-date and accurate, this does not always appear to be the case. Evidence of this is to be found in Carslaw and Mills (1992) (hereafter, C&M), who reported a deficiency in American intermediate accounting textbooks with respect to cash flow ratio analysis. The nature of ratios used in financial statement analysis is subject to development and change, requiring changes in what we teach to reflect what is done in practice. Therefore, with the aim of informing educators and textbook authors, this paper reports a survey of the financial statement analysis chapters of Australian introductory accounting textbooks that considers the extent to which: 1. the ratios recommended in them are consistent; 2. they include the ratios found to be deficient in American textbooks by C&M and recommended by C&M; and 3. they include ratios used in practice. 1 LITERATURE REVIEW Ratio analysis has emerged as the main tool used to carry out financial statement analysis (Gallizo, Jiménez & Salvador 2003) and is a standard component of introductory accounting and finance courses in both undergraduate and coursework masters’ business programs. While it might be assumed that authors of introductory accounting and finance textbooks would update their material to reflect current practice in a timely fashion, this is not necessarily the case. American textbooks have been shown to be slow to integrate cash flow statement analysis after the introduction of mandatory standards requiring companies to produce this statement (C&M). We are unaware of any similar Australian studies or prior surveys of the financial statement analysis chapters of Australian introductory accounting textbooks. Many of these textbooks are adaptations of American texts but whether the deficiencies found by C&M fifteen years ago have been addressed is unknown. Our study compares Australian textbook coverage of cashflow ratios to C&M and extends C&M by considering all ratios. We also extend the C&M study by comparing textbook coverage with practice. A listed company’s annual report is widely considered to be the most important source of public information available to investors and can have a significant impact on investment decision making. While the financial statements are regulated and audited, other sections of the report, which mostly contain voluntarily disclosed information, have long been known to be more commonly relied on by unsophisticated investors (Lee & Tweedie 1975). One of these sections is the historical summary, which provides key financial data, usually including ratios, over a five- or ten-year period. Other sections of the report also contain ratio data, sometimes in graphical form. Since most ratios are disclosed in the report on a voluntary basis, it follows that those ratios are viewed by management as having some significance to investors and other users. This is in line with literature suggesting that voluntary disclosures will only occur where the benefits of the disclosure are expected to outweigh the costs (Bhojraj, Blacconiere & D’Souza 2004). While a significant number of Australian and international studies have sought explanations for voluntary disclosures in company reports (for example, Whittred 1987; Bradbury 1992; McKinnon & Dalimunthe 1993; Hossain & Adams 1995; Camfferman & Cooke 2002), these studies have not specifically investigated ratio disclosures, instead focusing on the overall level of information voluntarily disclosed. An exception is Watson, Shrives and Marston (2002) but their study of voluntary disclosure of accounting ratios by UK companies did not report the specific ratios disclosed, only broad categories. Furthermore, the data from their study is now quite old, being based on annual reports from 1989 to 1993 and advances in financial statement analysis have appeared in the academic literature in the intervening years; for example extensions upon traditional Du Pont analysis (Firer 1999; Tezel & McManus 2003). 2 Two recent Australian studies shed some light on the ratios important in practice. The first (Beattie & Jones 1999) examined financial graphs in the annual reports of top 100 companies in Australia. This study, though not focussed on ratio disclosure specifically, found that earnings per share and dividends per share were reported in graphs in just over 35% of 89 annual reports. Return on capital employed (using various definitional forms) and net asset value per share were also reported in graphical form. The second study (Mather & Peirson 2006) examined financial covenants in 36 public and 41 private debt contracts. The study found that interest cover, dividend cover and current ratios formed part of some public and private debt covenants and, in addition, accounts receivable and other turnover ratios were specified in private debt covenants. METHOD This paper compares the content of the financial statement analysis chapter of textbooks to each other and to practice. Ratios used in practice were determined by investigating the nature of the ratios disclosed by companies in their annual reports and by surveying the ratios used by online investment service providers. Thus, data for this research was collected predominately through content analysis of company annual reports, relevant websites and introductory accounting texts. Each of these is now outlined. A list of accounting texts aimed at an Australian introductory-level university student audience was developed for this study based on lists provided by representatives from leading textbook publishers and lists available from a major textbook retailer. All texts identified in this way contained a chapter on ratio (or financial statement) analysis. The list of 11 texts included in the sample for this study is provided in Table 1. The ratios included in the ratio chapter in each of these textbooks were compiled, along with their categorisations and definitions. [Insert Table 1 here] Financial ratios used in practice were defined to be those reported in company annual reports and those reported in online financial databases. While several online financial databases and investor websites exist, FACTIVA (2007), Commsec (2007), Yahoo!7 Finance (2007), MSN.Money (2007), Investopedia (2007), About.com (2007) and the ASX (2007) beginners online course were used in this study due to their size and popularity among investors. The sites are also representative of those listed in Kinsky’s (2007) widely used Australian popular book on online investing. The sites report ratios for individual listed companies or provide introductory guides to ratio analysis. Companies were selected from the ASX All Ordinaries Index constituent list at 30 June 2005, which consisted of 485 of the largest listed Australian companies by market capitalisation. Larger firms were the focus of this study because ratio disclosure and innovation is more likely to be found in larger companies (Watson, Shrives & Marston 2002). Companies in the Financials and Energy Global 3 Industry Classification Standard (GICS) sectors were excluded, as were companies in the
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